The Moderating Effect of Market-Specific Factors on the Return Predictability of Investor Sentiment

Abstract

This paper examines the return predictability of investor sentiment in 12 Asian and European markets during the period between 2004 and 2016. Employing the composite sentiment index constructed from the consumer confidence index ( CCI), advance/decline ratio ( ADR), and volatility premium ( VP), we find a strong negative relationship between investor sentiment and the next 3 to 24-month returns. This outcome implies that sentiment could be a contrarian predictor of market returns over various periods. Moreover, we reveal an essential role of local factors, including financial development, institutional governance, and culture, in the sentiment-return diversification among regional markets. We discover that the moderating effect of market-specific factors is time-varying and different between Asian and European areas. As a result, sentiment has a shorter-term impact in Europe but a longer-term impact in Asia.